OTC Markets Group — A year of investment for the future

Exhibit 1 provides a comparison of OTCM’s Q219 profit and loss result with prior quarters and we pick out key points below. Percentage changes cited are from Q218 unless stated.

Exhibit 2 gives a more detailed analysis of costs and, as mentioned, this underlines the significant increase in compensation and IT-related costs. The increase in staff costs partly reflects a rise in staff numbers from 91 at end June last year to 99 this year. This arises from the acquisitions and additions to support development of the business. OTCM reports that the employment market remains competitive, particularly in IT, and the annual increase in base salaries was approximately 6% to aid retention of skilled staff. The sharp, 19%, increase in IT costs was a result of acquisitions and the need to ensure the security and reliability of systems, not least because of obligations under regulation Systems Compliance and Integrity (SCI). Otherwise, occupancy costs were up by a third year-on-year but down by nearly 30% sequentially, reflecting the increased costs related to the new headquarters year-on-year and, quarteronquarter, the one-off move costs incurred in Q119. As shown on the bottom row of the table, excluding those one-off costs, total costs were only modestly ahead sequentially.

We show selected quarterly operating metrics in Exhibit 3.

Within OTC Link the two features to note are the progressive addition of new subscribers to OTC Link ECN and a resumption of the erosion in the number of active Link ATS participants as the longer-term trend towards consolidation continues in response to margin and other pressures.

The Corporate Services figures show an increase in the number of OTCQX companies with stronger sales in FY18 and H119, fewer downgrades and a higher retention rate for FY19 (94%) all contributing to the 15% y-o-y increase. International companies (primarily Canadian and including companies in the cannabis-related sector) are noted as a growth driver with 19 joining in the period. OTCQB saw a modest reduction in its corporate client count compared with the prior-year period, with a lower number of new joiners in the quarter and a similar level of cancellations.

Within Market Data Licensing there was a near 4% increase in professional users year-on-year while the relatively volatile (and lower revenue) non-professional users declined by 9%. Not shown in the table but compliance file users (a growth area for OTCM) increased from 22 to 31 y-o-y and at 1 August had grown to 33 custodians, banks and broker dealers.

Two further states, Kentucky and North Dakota, have been added to the list of those that grant Blue Sky recognition to the OTCQX and OTCQB markets. This takes the totals to 36 states for OTCQX and 33 for OTCQB (see Exhibit 4). As a result, population coverage now stands at 55% and over 53%, respectively. OTCM continues to work towards further regulatory recognition and it is hoped that adoption of a model rule by the North American Securities Administrators Association will facilitate further states granting recognition. Blue Sky recognition is not directly linked to revenue generation but progress towards 100% coverage should be increasingly positive reputationally, helping to attract a broader range of corporate clients to OTCM’s premium markets.

OTCM highlighted three new product developments launched in the second quarter, examples of the company’s initiatives to broaden its offering and enhance its services to its corporate customers and market users.

To set the scene we include our normal table showing the recent performance of selected equity market indices (Exhibit 5). This shows positive performance for all but OTCQB year to date. The markets with more of a venture profile, OTCQB, TSX Venture and AIM, have all been weaker than the remaining markets, reflecting a cyclical period of outperformance for larger companies.

Exhibit 6 and 7 show IPO numbers for Nasdaq, and the Canadian TSX and TSX Venture exchanges as indicators of corporate and market confidence and activity. This broadly shows a similar pattern to the equity index performance outlined above. The number of IPOs on Nasdaq in the second quarter was 7% above the prior-year period at 60, while the first half count was 4% higher at 97. On the Canadian exchanges, TSX IPOs in the first four months of the year were down 3%, whereas TSX Venture was 19% below the prior-year period. Not shown here, but the number of new admissions to AIM in the first seven months of 2019 were down 62% with the marked weakness likely to reflect continuing political uncertainties in the UK.

Near-term market dynamics such as those highlighted above may affect activity levels for OTCM including trading activity for OTC Link and the appetite of corporates to sign up to its services, but on a longer view development of online/crowdfunding capital raising could create a larger population of potential clients with an appetite to use OTCM’s cost effective secondary markets. On this front the extension of Regulation A+ to SEC reporting issuers in January was seen as a positive development while OTCM also welcomes the publication of the SEC’s Harmonisation of Securities Offering Exemptions concept release that seeks feedback on ways to simplify and improve the framework of offering exemptions to ease capital raising while still protecting investors.

OTCM’s own focus and strategy is unchanged, aiming to create better informed and more efficient financial markets through sharing information on open networks, connecting broker-dealers to create organised markets and providing reliable, cost-effective, subscription-based technology solutions.

The changes in key numbers within our estimates are summarised in Exhibit 8, with further detail included in the financial summary in Exhibit 11. Our revenue assumptions are marginally higher with small increases for OTC Link and Corporate Services and reductions for Corporate Services. We had already increased our operating expense assumption after the Q1 results and now make a further 3% increase to allow for the investment the company has made in staff and IT costs. The resulting EPS estimate reductions are 6% and 3% for this year and next.

The balance sheet remains strong with net cash of $24.1m at the end of the quarter ($22.4m end Q119) or $25.7m including restricted cash. First-quarter cash flow showed a spike in spending within investing activities, reflecting the cash element of the Qaravan acquisition, spending associated with the headquarters move and data-centre upgrades. The headquarters and acquisition spending dropped out in the second quarter, but data centre investment has continued and is expected to be completed by the end of 2019. Absent further acquisition opportunities, we expect investment spending to revert to a lower level, with a figure of $1.3m assumed in our estimate for FY20, for example.

OTCM shares are up 24% year to date compared with 48% for the information providers and 29% for global exchanges on average. This, combined with earnings estimate changes (consensus for global exchanges and information providers), has left OTCM on prospective PERs below those for information providers and similar to the average for global exchanges (see Exhibit 9 below).

The sensitivity of our discounted cash flow valuation to different discount rate and long-term growth assumptions is illustrated in the next table. The model factors in our explicit forecasts for FY19/20 together with an assumption of FY21–22 cash flow growth of 5%, long-term growth of 4% and a terminal cash flow multiple of c 22x, compared with the current year value of 27x.

While our FY19 and FY20 estimates have been reduced, it reflects the effect of investment in new products, acquisitions and staff that should generate increased revenue growth and hence improved cash flows. Our longer-term cash flow assumptions are little changed and, taking this and the comparator valuations into account, we keep our fair value unchanged at $37.00 per share.